EXECUTIVE SUMMARY
| PROVISIONS IN THE ECONOMIC
GROWTH AND TAX RELIEF Reconciliation
Act of 2001 raised ESOP contribution limits and
liberalized companies’ combined use of ESOPs and
401(k) plans. The new law raises the
contribution limits that can be added annually
to an individual employee’s account—from both
employer contributions to ESOPs and other
defined plans. It also raises the maximum amount
an individual can defer into a 401(k) plan to
$11,000 from $10,500.
EMPLOYEES’ ELECTIVE
DEFERRALS INTO their 401(k) plans
will no longer reduce the tax-deductible limit
on the amount the employer can contribute to a
defined contribution plan (ESOP) or
combination of plans. CPAs should explain the
wide-ranging implications of these changes to
their clients so they can incorporate them
into their benefit plans and take full
advantage of these provisions.
NEW PROVISIONS IN THE TAX
LAW address some S corporations’
abuse of ESOP tax benefits by closing
previously existing loopholes. The law
requires plan managers to perform a two-step
process to determine whether the S corporation
and the ESOP participant will be subject to
punitive tax treatment by identifying
“disqualified” persons and determining whether
the disqualified individuals own at least 50%
of all shares.
C CORPORATIONS ARE NOW
ALLOWED to deduct dividends paid on
allocated and unallocated shares that
employees voluntarily reinvest in company
stock in the ESOP. Dividends that are
reinvested by the employee into company stock
are taxable to the employee. But the company
can create a dividend “switchback” program
that will provide the equivalent of a pretax
dividend.. | BRYAN GIRARD is director of
communications for the National Center for
Employee Ownership in Oakland, California. His
e-mail address is bgirard@nceo.org
. |
lthough employee stock ownership plans
have existed for more than 25 years as an employee
benefit and a retirement tool, their legal structure
continues to evolve. With the Economic Growth and Tax
Relief Reconciliation Act of 2001, Congress enacted
significant changes, effective in 2002, to employee
benefit plans which raised the total dollar amount of
contribution limits and liberalized companies’
combined use of ESOPs and 401(k) plans (for more
information on the tax bill, see “ Making
Sense of the New Tax Legislation ,” JofA
, Sep.01, page 22). This article discusses how
the legislation has affected ESOP use and recommends
CPAs and plan sponsors review the changes with their
corporate and small business clients so they can
realize tax benefits associated with the new rules..
NEW
CONTRIBUTION LIMITS Public
companies often use ESOP contributions to
match employee deferrals to a 401(k) plan;
private companies tend to use them to
supplement diverse retirement
plans. The new law raises the allowable
combined total of employee deferrals to
401(k) plans plus employer contributions to
ESOPs, 401(k) and other defined contribution
plans to $40,000 from $35,000 and to 100% of
an individual’s eligible pay from 25%,
whichever is less. The maximum amount that
an employee can defer annually to a 401(k)
plan has been increased to $11,000 from
$10,500 (see exhibit 1, below). These
dramatic changes allow lower- and
middle-income employees to save more money
for retirement. |
ESOPs a Widespread
Benefit As of 2001
approximately 8.5 million
employees participated in about
11,400 employee stock ownership
plans with an aggregate value of
more than $400 billion. Although
no precise data are available,
experts believe 5% to 10% of ESOPs
are in publicly traded companies
and this group contains the
majority of plan assets.
Source: The National Center for
Employee Ownership, Oakland,
California, www.nceo.org
. | |
These revisions provide a solution
for companies that in the past sometimes found they
had to terminate their 401(k) plans after creating an
ESOP program because their ESOP contributions already
were approaching the limits. “Telling employees they
could no longer have a 401(k) plan could be a
significant disadvantage for companies,” says Dennis
Long, president of Appleton, Wisconsin-based BCI
Group, the country’s largest ESOP/401(k)
administration company. Formerly, companies
contributing the maximum to an ESOP (25% of each
employee’s pay per year) were precluded from having a
401(k) plan; companies that neared the maximum were
confined to 401(k) plans with limited funding. The tax
law of 2001 virtually eliminates this problem.
Exhibit 1:
Snapshot of Plan Changes |
| 2001 |
2002 |
2003 |
2004 |
2005 |
2006 |
2007-2009
| | (
Old law) | | |
| | |
| Employee
elective deferrals counted as employer
contributions | Yes | No: 2002 through 2009 (Note:
employee deferrals will still count
toward annual addition limits)
| Employee deferrals
counted as compensation for calculating
maximum amount of employer contribution
| No | Yes: 2002 through
2009 | | |
| | |
Maximum deduction for contributions
to all defined defined contribution
plans combined under IRC section 404
| 15% of pay for combined
contributions to all defined
contribution plans; 25% where there is a
C corporation leveraged ESOP or ESOPs
combined with money purchase pension
plan | 25% for
combined contributions to all defined
contribution plans for 2002 through 2009
| Catch-up contributions
for individuals 50 and older |
None | Additional $1,000
| Additional $2,000 |
Additional $3,000 |
Additional $4,000 |
Additional $5,000 |
Additional $5,000 |
401(k) deferrals | $10,500
| $11,000 | $12,000 |
$13,000 | $14,000 |
$15,000 | Indexed in annual
$500 increments for inflation |
Covered compensation eligible for
contributions | $200,000 |
| | | Indexed in annual $5,000
increments for inflation |
| Annual additional dollar
limits (employer contributions plus
covered employee deferrals plus
forfeitures) under IRC section 415 |
$35,000 or 25% of compensation,
whichever is less | $40,000 or 100% of covered
compensation, whichever is less |
Indexed in annual $1,000
increments for inflation |
| |
Two kinds of contribution limits now affect
businesses. The first, IRC section 404, governs how
much a company can deduct from its taxes for its
contributions to a retirement plan; the second, IRC
section 415, stipulates how much employers and
employees can add to individual employee accounts.
Employees’ elective deferrals to their 401(k) plans
will no longer reduce the tax-deductible limit on the
amount the employer can contribute to a defined
contribution plan (ESOP) or combination of plans. CPAs
should explain the wide-ranging implications of these
changes to their clients so they can incorporate them
into their benefit plans and take full advantage of
these provisions. Under prior law if a company
did not borrow money through an ESOP (or if the
company was an S corporation ESOP), the maximum annual
contribution limit to the ESOP was 15% of total
eligible pay. The new limit is 25% of pay for all ESOP
plans. Moreover, companies can take a tax deduction
for “reasonable” dividends—which the IRS defines as
those “that are justified by earnings and in line with
standard industry practice”—paid on ESOP shares that
employees voluntarily reinvest in the plan to buy more
company stock (for an example of how the changes work,
see exhibit 2, below).
Exhibit 2:
Example of Plan Changes on Employee
Contributions |
Assumptions:
Total payroll of eligible plan
participants: $2 million.
Target leveraged ESOP
contribution: 20% of eligible pay.
Total annual payroll over
$170,000/year per person: $200,000.
Total annual payroll over
$200,000/year per person: $50,000.
Amount employees defer annually
to 401(k) plan: $200,000.
Sample employee’s annual gross
earnings: $50,000; annual 401(k) contribution:
$5,000.
Maximum Allowable Contribution to ESOP
| 2001 Law
| 2002 Law
| Eligible pay for ESOP
contributions | $2
million minus: $200,000 in pay over
$170,000 per year per individual
Employee 401(k) deferrals |
$2 million minus:
$50,000 in pay over $200,000 per year
per individual | Maximum deductible corporate
| 25% of remaining
amount (Number to be determined when
deferrals are made) | 25% of remaining amount
($1.95 million x .25) |
Limit on annual addition
to employee’s account in leveraged ESOP
| $12,500 (25% of pay)
Includes both ESOP contributions and
401(k) deferrals | $40,000 (the lesser of
$40,000 fixed ceiling or 100% of pay)
| Dollar limit
on employee’s 401(k) deferral | $2,500 (limited to 5% of pay
if ESOP contribution is 20% of pay)
| $11,000 (fixed
ceiling) | Deductible corporate ESOP
contribution in dollars if company
contributes 20% of aggregate eligible
pay | .20 x [$1.8
million minus employee deferrals to
401(k)] ($1.8 million reflects
$200,000 ineligible pay over $170,000
per year per person. Size of deferrals
depends on how much employees defer,
which may be reduced by limits on
maximum allowed, that is, 5% of pay
per individual) | .20 x $1.95 million
Reflects only the $50,000 of
ineligible payroll (pay over $200,000
per year per individual) |
|
SCRUTINY OF S CORPORATIONS By
closing previously existing loopholes, the legislation
also addresses some S corporations’ abuse of ESOP tax
benefits. New provisions essentially prevent very
small companies controlled by only a handful of people
from setting up ESOPs primarily for their own
financial gain. The law requires plan managers to
perform a two-step process to determine whether the S
corporation and the ESOP participants will be subject
to punitive tax treatment:
Identify “disqualified persons.”
Under the law a “disqualified person” is
an individual who owns 10% or more of the allocated
and unallocated shares in the ESOP or who, together
with family members (spouses or other family members,
including lineal ancestors or descendants, siblings
and their children or the spouses of any of these
other family members), owns 20% or more of such
shares. Synthetic equity, broadly defined to include
stock options, stock appreciation rights and other
equity equivalents, is also counted as ownership for
this purpose.
Determine whether disqualified individuals own
at least 50% of all shares. In order
for plan managers to calculate the total number of
shares disqualified individuals own, they must count
shares held directly, shares owned through synthetic
equity and allocated or unallocated shares owned
through the ESOP. If disqualified individuals
own at least 50% of the company’s stock and receive an
allocation from the ESOP during the current year, they
will incur a substantial tax penalty. An allocation
occurs when ESOP shares are added to a participant’s
account; the allocation will be taxed as a
distribution to the recipient, and a 50% corporate
excise tax will apply to the fair market value of the
stock allocated. If the recipient owns synthetic
equity, an additional 50% excise tax will apply to its
value. In the first year this rule applies, there will
be a 50% tax on the fair market value of shares
allocated to disqualified individuals even if no
additional allocations are made to those individuals
during that year. Thus, the tax applies if
disqualified individuals own more than 50% of the
company in the first year.
These
regulations apply to existing plans,
regardless of when they were established, if
their purpose is to avoid or evade the
prohibited allocation rule (see “S Corporation
Election Rules,” at right). David Johanson, a
specialist in employee stock ownership plans
at Johanson Berenson LLP, a Napa, California,
law firm, observes that to ensure compliance
with the new law and to minimize adverse tax
consequences, advisers will have to carefully
review situations in which a small number of
related people will receive substantial
allocations of company stock under an S
corporation ESOP. Donald Israel, CPA,
principal of Benefit Concepts Systems Inc. in
New York City, concurs. “The new law prevents
individuals from trying to establish S
corporation ESOPs for their own gain, rather
than for the exclusive benefit of the ESOP
participants and their beneficiaries, as
Congress originally had intended,” he says.
|
S Corporation
Election Rules
Grandfather rules apply to
existing plans only where the ESOP
was established by March 14, 2001,
and had an S corporation election
in place by that date. The
legislation clarified that
although an election to be an S
corporation was effective as of
the date the election first
applied, a company could not make
a retroactive election after March
14 and qualify for grandfather
treatment. | |
DIVIDEND TREATMENT FOR C CORPORATIONS
Certain ESOP incentives available to C
corporations are not available to S corporations. For
example, unlike S corporations, C corporations are
allowed to have a different class of stock and are
able to deduct dividends. The new law allows C
corporations to deduct dividends paid on allocated and
unallocated shares that employees voluntarily reinvest
in company stock in the ESOP. Under prior law C
corporations could deduct dividends they paid on
allocated or unallocated ESOP shares to repay an ESOP
loan. C corporations also were able to deduct
dividends passed directly through to employees.
Dividends an employee reinvests into company stock are
still taxable to the employee but the company can
create a dividend “switchback” program that will
provide the equivalent of a pretax dividend to the
employee. The new law allows for a simple
procedure under which both the employer and the
employee can avoid tax on the dividend. “The C
corporation can now deduct the dividend if the
employee reinvests it as employer stock directly in
the ESOP,” says Nancy K. Dittmer, CPA, of RSM
McGladrey Inc. in Des Moines, Iowa. “There is no need
for the dividend switchback program unless the
employee wants to reinvest on a pretax basis in the
401(k) for investment diversification purposes.”
Dittmer notes that if the employee decides to reinvest
the dividend as employer stock into the ESOP, the
reinvestment does not apply toward the employee’s
401(k) deferral limit ($11,000) or other contribution
limitations. To create a deductible dividend under the
old law, companies had to obtain letter rulings from
the IRS for dividend switchback arrangements. (Recent
IRS rulings have made it clear, however, that S
corporation ESOPs can use dividends paid only for
unallocated shares as repayment for an ESOP loan and
even then such dividends are not deductible.)
The new approach may be of particular interest to
public companies because they are allowed to deduct
the dividend. For private companies it could mean
considerable expense to comply with regulations the
SEC imposed. For example, a private company could
spend $10,000 to $25,000 to file for an exemption to
the dividend laws and to file an antifraud disclosure
statement, with no guarantee of obtaining the
exemption. If the company does not receive an
exemption and then wishes to register its shares for
public trading, it faces significant initial and
ongoing expenses related to registration,
administration and reporting.
WATCH
WHAT CONGRESS DOES An ESOP is a
flexible financial vehicle for corporate
growth, and like other tax-qualified
retirement plans, it must comply with
participation, benefit allocation and
distribution rules (exhibit 3, at right,
lists some of the available plan resources).
As a result of the publicity surrounding
Enron because its employees lost retirement
savings, proposals to address the
vulnerabilities in defined contribution
retirement plans have appeared from
Congress, regulators and employee/investor
associations. President George W. Bush
proposed his own series of legislative
controls and a number of other plans are on
the table. As of this writing none of the
proposed bills would affect private-company
ESOPs in any way (by requiring earlier
diversification in ESOPs). Public company
ESOPs integrated with 401(k) plans, however,
could be subject to new rules on
diversification rights and other issues.
The new tax law makes ESOPs more
attractive and makes it much easier for
companies to combine ESOPs with 401(k)
plans. Despite a recession and negative
perceptions of employer stock in pension
plans brought about by the collapse of
Enron, these plans are here to stay—private
company ESOPs continue to emerge and public
companies are standing behind their ESOPs
and 401(k) plans. CPAs need to be familiar
with the reforms and their timing to
maximize the new plan features for their
clients. |
Exhibit3: ESOP Resources
| Buck Consultants, www.buckconsultants.com
. International employee benefits
consultants with headquarters in New
York City.
The ESOP Association of
America, www.esopassociation.org
. A trade association that
lobbies for ESOP companies and
tracks legislation.
The Foundation for
Enterprise Development, www.fed.org
. The foundation focuses on
entrepreneurial employee ownership
with a particular emphasis on
technology businesses.
The Global Equity
Organization, www.globalequity.org
. GEO is a worldwide membership
organization of companies and
consultants dealing with
international and multinational
equity compensation concerns.
The National Center for
Employee Ownership, www.nceo.org
. The NCEO is a nonprofit
membership and research organization
offering a newsletter, legal
journal, publications, conferences
and seminars on broad-based employee
stock ownership plans. | |
|